Incomplete Contracts Literature Research Articles

Outsourcing Public Services: Contractibility, Cost, and Quality

AbstractWe review the literature on public sector outsourcing to explore if the theoretical predictions from the incomplete contracts literature hold up to recent empirical evidence. Guided by theory, we arrange services according to the type and magnitude of their contractibility problems. The empirical studies point at rather favourable outsourcing outcomes, in terms of costs and quality, for services without severe contracting problems. The picture is more mixed for services with tougher contracting problems, with the weight of the evidence in favour of public provision. This difference between services is largely in line with the property-rights framework and theories of incomplete contracts.

Outsourcing Public Services: Contractibility, Cost, and Quality

We review the literature on public sector outsourcing to explore if the theoretical predictions from the incomplete contracts literature hold up to recent empirical evidence. Guided by theory, we arrange services according to the type and magnitude of their contractibility problems. The empirical studies point at rather favourable outsourcing outcomes, in terms of costs and quality, for services without severe contracting problems. The picture is more mixed for services with tougher contracting problems, with the weight of the evidence in favour of public provision. This difference between services is largely in line with the property-rights framework and theories of incomplete contracts.

Intangible Assets and the Organization of Global Supply Chains

This paper introduces the concept of intangible assets in sequential supply chains and the importance of their appropriability in the organizational decision of firms. We focus on the quality of intellectual property rights (IPR) institutions, which on top of the hold-up problem between a supplier and the final producer entails an additional risk of imitation as technology may leak to competing producers in the market. The level of IPR enforcement in the location of a supplier can therefore play a crucial role in determining the decision of a final good producer whether to outsource or integrate a particular stage of production. The analysis is performed with Antras and Chor (2013) in the background, where the position of the input along the supply chain, i.e. its upstreamness, and the degree of sequential complementarity of stage-specific inputs influence the organizational strategy of firms through the incentive structure of supplier investments. Our findings show that introducing intangible assets in sequential supply chain may have the opposite effect of contractibility on outsourcing decision, where only tangible property rights are considered. We argue therefore that the risk of imitation is a relevant feature that needs to be accounted for in the incomplete contract literature. Our theoretical predictions are validated on Slovenian firm-level data.

Contracts, Ownership, and Industrial Organization: Past and Future

We review the formal literature in industrial that incorporates organizational models of the rm into the analysis of industry behavior. Although many insights have been generated, this \organizational industrial organization is still in its early stages: a complete theory of the relationship between organizational design and traditional IO variables such as price, quantity or welfare has yet to be developed. We show how the insights emanating from the incomplete contract literature can be used to address these questions and others of interest to both IO and economists: endogenous heterogeneity; the role of liquidity and surplus division in organizational design; the relationship between product price, industry supply and organizational choices; the response of industry supply to shocks in fundamentals.

Contracting institutions and product quality

For many goods, quality improvements involve the use of more sophisticated, higher quality inputs. The production of these sophisticated inputs requires greater collaboration between suppliers and final good producers, with suppliers developing relationship-specific inputs, and final good producers customizing their production processes to incorporate them. In countries with poor legal institutions, the relationship-specific investments needed to achieve strong collaboration, and by extension more sophisticated inputs and higher quality outputs, will arguably be hard to achieve. As the incomplete contracts literature suggests, doubts over contract enforcement will render the return on relationship-specific investments less certain, rendering both suppliers and final good producers less willing to undertake the customization necessary to improve quality. Employing a difference-in-difference methodology on highly disaggregated US import data , this paper studies the impact of legal institutions on product quality. It finds that poor contracting institutions substantially impede a country’s ability to produce high quality final goods: in industries where the potential use of customizable inputs is extensive, countries with weaker contract enforcement regimes produce lower quality final goods.

Collaborative planning, forecasting and replenishment (CPFR) as a relational contract: an incomplete contracting perspective

This paper analyses collaborative planning, forecasting and replenishment (CPFR) from an incomplete contracting perspective. In the absence of economic incentive problems, CPFR enables trading partners to improve operational efficiency through a structured process of learning by both sharing and utilising information across firm-level boundaries. From a review of the incomplete contracts literature and a case study of the CPFR arrangement between P&G and Wal-Mart, this paper posits CPFR as a relational contract for managing economic incentive problems, which can arise in a vertical supply relationship due to transaction costs, agency costs, and relative bargaining positions. Theoretical propositions are developed regarding when this IT-supported intermediate form of vertical contracting is preferred to other governance modes and how CPFR can be an effective relational contract to support economic exchange and to create intellectual capital between trading partners. With efficient vertical coordination and enhanced specialisation incentives for mutual commitment, CPFR allows contracting parties to avoid the difficulties of formal contracting while realising the benefits that would be anticipated from vertical financial ownership.

Indescribability and its irrelevance for contractual incompleteness

The incomplete contracts literature often cites indescribable contingencies as a major obstacle to the creation of complete contracts. Using agents’ minimum foresight concerning possible future payoffs, Maskin and Tirole (Rev Econ Stud 66:83–114, 1999) show that indescribability does not matter for contractual incompleteness as long as there is symmetric information at both the contracting stage and the trading stage. This is called the irrelevance theorem. The following generalization of the irrelevance theorem is shown here: indescribability does not matter even in the presence of asymmetric information at the trading stage, as long as there is symmetric information at the contracting stage. This is an important clarification because Kunimoto (Econ Lett 99:367–370, 2008) shows that indescribability can matter if there is asymmetric information at both stages. It is thus argued that asymmetric information at the contracting stage is necessary for indescribability to be important in the rational agents contracting model.

I contratti di programma: una questione di multitask?

- In the light of the results from a wide empirical investigation, this essay examines some crucial characteristics of the Italian policy measure called Contratti di programma through both the analytical framework of the incomplete contracts literature and the multi-task Principal-Agent theory. The Contratti di programma policy is based on a formal agreement between the Italian Government and private firms to carry on an investment programme comprising a number of different projects (industrial investments; workers training programs; research centres and projects). The essay also provides a number of suggestions for improving the effectiveness of this policy. Keywords: multitask, asymmetric information, incomplete contracts, industrial policy Parole chiave: multitask, informazione asimmetrica, contratti incompleti, contratti di programma, politica industriale Jel Classification: D82; D86; L14; L52

Organizational Economics and Models of Incomplete Contracts

The article considers interrelations between economic organization and the opportunities of realizing technological advantages such as demand aggregation, team production and asset specificity. Theoretical results of incomplete contracts literature are analyzed (Hart-Moore, Grossman-Hart and Tirole-Furubotn-Richter models) which touches upon interdependence between contract incompleteness, allocation of property rights and the levels of relationship-specific investment.

Hold-Up, Asset Ownership, and Reference Points*

This paper reexamines some of the themes of the incomplete contracts literature—in particular, the hold-up problem and asset ownership—through a new theoretical lens, the idea that contracts serve as reference points (see Hart and Moore [2008]). We consider a buyer and seller who are involved in a (long-term) economic relationship where the buyer’s value and seller’s cost are initially uncertain. For the relationship to work out, the parties need to cooperate in ways that cannot be specified in an initial contract. Suppose that the parties write a rigid contract that fixes price. Such a contract works well in “normal” times because there is nothing to argue about: we assume that, in the absence of argument, the parties are willing to cooperate. However, if value or cost falls outside the normal range, one party will have an incentive to threaten to withhold cooperation unless the contract is renegotiated; that is, the party will engage in hold-up. For example, if value is unusually high, the seller will hold up the buyer to get a higher price, whereas if cost is unusually low, the buyer will hold up the seller to get a lower price. We suppose that hold-up transforms a friendly relationship into a hostile one. The consequence is that the parties withhold cooperation: they operate within the letter, rather than the spirit, of their (renegotiated) ∗ I am grateful to John Moore for discussions of some of the elements of this paper and to Bob Gibbons and Birger Wernerfelt for many helpful conversations. I would also like to thank Ronen Avraham, Mathias Dewatripont, Florian Englmaier, Rob Gertner, Victor Goldberg, Louis Kaplow, Josh Lerner, Bentley MacLeod, Jeremy Stein, Sasha Volokh, Abe Wickelgren, and Christian Zehnder for useful comments, and Georgy Egorov for excellent research assistance. Four referees, an editor (Larry Katz), and a second editor provided highly constructive input. Financial support from the U.S. National Science Foundation through the National Bureau of Economic Research is gratefully acknowledged.

Flexibility provisions in multilateral environmental treaties

In international politics, intergovernmental treaties provide the rules of the game. Similar to private law, treaty designers face a trade-off between flexibility to adjust to unforeseen contingencies and the danger that the binding nature of the treaty and hence, the level of commitment by treaty members, is being undermined if the treaty can be amended too easily. In this paper, we address this problem in the analytical framework of institutional economics, drawing in particular on the incomplete contracts literature. Furthermore, we derive preliminary hypotheses and operational concepts for the measurement of flexibility in international treaties. Based on 400 treaties and supplementary agreements from the field of international environmental law, we provide new insights into the combined application of rules for adoption and entry into force of amendments, as well as provisions for conflict resolution and interpretative development. Using correspondence analysis, we show that treaty provisions can be represented in a two-dimensional property space, where treaties can be arrayed according to the degree of institutionalisation as well as along a flexibility dimension.

An Incomplete Contract Perspective on Public Good Provision

Abstract. This paper surveys what can be learned from recent advances in the incomplete contract literature to understand how public goods are or should be provided. The paper starts with a section on the full information case that presents and discusses the classical Samuelson condition on the optimal provision of public goods. The rest of the paper presents results under asymmetric information. It is constituted of two main parts. In the first one, the social planner has complete contracting ability. We discuss the basic setting and assumptions of this comprehensive contracting approach and study the trade-offs it generates. The second part of the paper is devoted to the study of contracting incompleteness. Such incompleteness can emerge from various sources, which we present and discuss. We then study the case of a politically chosen decision-maker and the consequences of its inability to commit for more than one period and of the ability for individuals to form groups. Finally, we address the problem of the choice between public and private forms of public good provision. The concluding section summarizes the main policy lessons.

Cosmetic Compliance and the Failure of Negotiated Governance

Across a range of legal regimes - including environmental, tort, employment discrimination, corporate, securities, and health care law - United States law reduces or eliminates enterprise liability for those organizations that can demonstrate the existence of effective internal compliance structures. Presumably, this legal standard rests on an assumption that internal compliance structures reduce the incidence of prohibited conduct within organizations. This Article demonstrates, however, that little evidence exists to support that assumption. In fact, a growing body of evidence indicates that internal compliance structures do not deter prohibited conduct within firms and may largely serve a window-dressing function that provides both market legitimacy and reduced legal liability. This leads to two potential problems: (1) an under-deterrence of corporate misconduct, and (2) a proliferation of costly - but arguably ineffective - internal compliance structures. The United States legal regime's enthusiastic embrace of internal compliance structures as a liability determinant is consistent with the increasing influence of what are referred to in this Article as models that seek to improve government regulation and/or the litigation process through more cooperative governance methods that provide a governance role to the regulated group and other interested parties. Drawing on the incomplete contracts literature, this Article argues that, although the negotiated governance model provides valuable descriptive insights into the mechanisms by which legal rules develop, the model's proponents minimize the dangers of opportunistic behavior during the renegotiation phases of governance (that is, the implementation and enforcement phases) by those with the greatest stake in the meaning of incomplete law - in this case, business organizations and legal compliance professionals, including lawyers.

From Walrasian General Equilibrium to Incomplete Contracts: Making Sense of Institutions

This paper explores the specific contribution of recent literature on incomplete contracts in comparison with the acontractual Walrasian general equilibrium as well as the complete optimal contracts of the Agency theory regarding the institutional identity of agents. It underlines a tension between the theoretical justification of contractual incompleteness on the one hand, and rationality postulate, on the other hand. It concludes the relevance of bounded rationality assumption to overcome some logical incoherencies of present incomplete contracts literature.

Flexibility Provisions in Multilateral Environmental Treaties

In international politics, intergovernmental treaties provide the rules of the game. Similar to private law, treaty designers face a trade-off between flexibility to adjust to unforeseen contingencies and the danger that the binding nature of the treaty and hence, the level of commitment by treaty members, is being undermined if the treaty can be amended too easily. In this paper, we address this problem in the analytical framework of institutional economics, drawing in particular on the incomplete contracts literature. Furthermore, we derive preliminary hypotheses and operational concepts for the measurement of flexibility in international treaties. Based on 400 treaties and supplementary agreements from the field of international environmental law, we provide new insights into the combined application of rules for adoption and entry into force of amendments, as well as provisions for conflict resolution and interpretative development. Using correspondence analysis, we show that treaty provisions can be represented in a two-dimensional property space, where treaties can be arrayed according to the degree of institutionalisation as well as along a flexibility dimension.

On indescribable contingencies and incomplete contracts

I examine the theoretical foundations underlying the incomplete contracts literature. A common justification for the assumption that contracts are not fully contingent on the state of nature is to point out that some aspects of the state may be unforeseen or indescribable to the contracting partners at the time the contract is written. I argue, however, that as long as risk-averse parties can foresee the probabilities of their possible payoffs, then the fact that they cannot describe the possible physical states does not matter; even with renegotiation, the parties can attain the same welfare as when full description is possible.

Taxing State and Local Government Production: Economic and Legal Perspectives

The Internal Revenue Service has held that the section 115 exclusion from taxation of the gross income state and local gov- ernments earn from public utilities or from the exercise of any es- sential governmental applies to any income that accrues to them. This provides an incentive for government to produce public goods and services rather than contracting with private firms, al- though the incomplete contract literature suggests economic wel- fare might be enhanced by private production. Examination of the Constitutional limitations on taxation of states and the difficulties of applying the essential governmental function test suggests any tax Congress levies must be subject to limitations implicit in the Tenth and Eleventh Amendments that require specificity. A start- ing point for such a tax structure might be the unrelated business income tax currently levied on the activities of tax-exempt organi- zations. Congress might focus on those activities that the incom- plete contract literature suggests would be better provided by pri- vate firms and that are financed with charges and fees.

Incomplete Contracts: Where do We Stand?

The paper takes stock of the advances and directions for research on the incomplete contracting front. It first illustrates some of the main ideas of the incomplete contract literature through an example. It then offers methodological insights on the standard approach to modeling incomplete contracts; in particular it discusses a tension between two assumptions made in the literature, namely rationality and the existence of transaction costs. Last, it argues that, contrary to what is commonly argued, the complete contract methodology need not be unable to account for standard institutions such as authority and ownership; and it concludes with a discussion of the research agenda.

Unforeseen Contingencies and Incomplete Contracts

We scrutinize the conceptual framework commonly used in the incomplete contract literature. This literature usually assumes that contractual incompleteness is due to the transaction costs of describing-or of even foreseeing-the possible states of nature in advance. We argue, however, that such transaction costs need not interfere with optimal contracting (i.e. transaction costs need not be relevant), provided that agents can probabilistically forecast their possible future payoffs (even if other aspects of the state of the nature cannot be forecast). In other words, all that is required for optimality is that agents be able to perform dynamic programming, an assumption always invoked by the incomplete contract literature. The foregoing optimality result holds very generally provided that parties can commit themselves not to renegotiate. Moreover, we point out that renegotiation may be hard to reconcile with a framework that otherwise presumes perfect rationality. However, even if renegotiation is allowed, the result still remains valid provided that parties are risk averse.